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Answer: In the Cox-Ingersoll-Ross model, the basis-point volatility of the short-term rate is presumed to be proportional to the square root of the rate, and short-term rates cannot be negative.
## Explanation Let's analyze each option: **Option A**: Incorrect. In the Ho-Lee model, the drift is time-dependent, not constant. The Ho-Lee model allows the drift to vary over time to fit the initial term structure. **Option B**: Incorrect. This describes a mean-reverting property, which is characteristic of models like Vasicek or CIR, not Ho-Lee. The Ho-Lee model does not have mean reversion. **Option C**: **Correct**. The Cox-Ingersoll-Ross (CIR) model has the following key features: - Volatility is proportional to the square root of the interest rate (σ√r) - The square root term ensures that interest rates cannot become negative - It incorporates mean reversion **Option D**: Incomplete statement, but the CIR model's volatility is indeed proportional to the square root of the interest rate. The CIR model is particularly suitable for interest rate modeling because it prevents negative interest rates while allowing for mean reversion and time-varying volatility.
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A CRO of a hedge fund is asking the risk team to develop a term-structure model that is appropriate for fitting interest rates for use in the fund's options pricing practice. The risk team is evaluating among several interest rate models with time-dependent drift and time-dependent volatility functions. Which of the following is a correct description of the specified model?
A
In the Ho-Lee model, the drift of the interest rate process is presumed to be constant.
B
In the Ho-Lee model, when the short-term rate is above its long-run equilibrium value, the drift is presumed to be negative.
C
In the Cox-Ingersoll-Ross model, the basis-point volatility of the short-term rate is presumed to be proportional to the square root of the rate, and short-term rates cannot be negative.
D
In the Cox-Ingersoll-Ross model, the volatility of the short-term rate is presumed to be...
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